Magazine

This Recovery Will Be a Slog

December 30, 2001

The year ahead will be a time for healing. The pain of September 11 wounded America's psyche--and its economy. But in the coming months, the forces of recovery that are now falling into place will lift the economy out of its 10th recession since World War II. The turnaround will go a long way toward raising the spirits of both households and businesses.

That's the general expectation of the 59 economists in BusinessWeek's 2002 outlook survey. The consensus view is that this recession will end around the first quarter of 2002, and for the year, real gross domestic product will grow by 2.5%--a big gain from the less than 1% rise expected for 2001.

But hold the applause. The recovery will be gradual and perhaps disappointing to some investors because it will follow an atypical downturn. The chief anomaly is that consumer spending has not tanked the way it usually does. "This recession differs considerably from those in the past in that it is a business-led recession, generated mainly by the consequences of a boom-bust cycle in business investment and the accompanying decline in equity prices," says William C. Dudley at Goldman, Sachs & Co. Consequently, the intense squeeze on profits has led to aggressive cost-cutting that is fueling a wave of layoffs. "The current business attitude in virtually all industries is, if any spending is nonessential, cut it," says Donald Straszheim at Straszheim Global Advisors in Los Angeles.

The good news is that the recession that began in March will likely be one of the mildest in the postwar era. By the second half, the forecasters expect real GDP growth to pick up. And by yearend, most economists look for the Federal Reserve to begin lifting interest rates, but only enough to shift monetary policy from its very accommodative mode to a more neutral stance.

Don't expect a return to the heady days of 4% to 5% real growth, soaring profits, and 30% gains in stock prices. Those days are gone. Instead, look for economic activity that's governed by fundamental relationships. Consumer spending will grow more closely with household income. Capital spending will be guided by profits and cash flow, and stock prices will rise in line with more sensible expectations for risk and reward.

The fearless forecasters at BusinessWeek agree with the survey's pattern but are a notch less optimistic about growth, given that the recovery faces some stiff headwinds. First, excess production capacity and inventories in the tech sector will work against a rebound in capital spending. Second, consumers will play less than their typical starring role in the upturn, as housing and auto sales have remained strong and thus have nothing to recover from. Finally, weak demand from abroad will not dissipate until after the U.S. recovery is established.

No one in the survey thinks these counterveiling forces will prevent a recovery, but nearly all believe they will limit the upturn's oomph. On average, the forecasters expect growth of 1.5% in the first half and 3.5% in the second. That's only a shade above the economy's sustainable, noninflationary pace of 3% or so. It's also well below the norm in past recoveries, when growth typically exceeded its long-term trend, a necessary condition for putting workers and machines idled by the recession back to work. The recovery's gradual pace will push the jobless rate to a peak above 6% in the second half, while inflation slows to below 2%.

The biggest obstacle to faster growth in 2002 is the fallout from past overinvestment in technology, which has depressed demand for new equipment and created a huge pileup of tech inventories, causing one of the most severe downturns in industrial output since the Great Depression. "The main headwind...is the investment overhang caused by the `irrational exuberance' of corporate management at the height of the Internet bubble," says Joseph Liro of Stone & McCarthy Research Associates. Or, as William C. Dunkelberg at the National Federation of Independent Business puts it: "This is a too-much-stuff recession." Too much capital equipment. Too much inventory. Too much labor.

Companies are making some progress with a little help from consumers, but the outlook for households is mixed. The biggest minuses are uncertainty over rising layoffs and the war against terrorism, both of which are depressing confidence, and the lack of pent-up demand that recessions usually generate. However, consumers have several plusses. "Once employment stops falling, the consumer sector will be well-supported by tax cuts, falling energy prices, and improved net worth--both from home values and stocks," says Richard D. Rippe at Prudential Securities Inc.

In addition, lower interest rates have unleashed a record volume of mortgage refinancings that is putting extra cash in people's pockets. And consumer balance sheets are in good shape. "The rise in gross assets in recent years, lifted especially by rising home prices, has been many times bigger than the increase in gross debts, which in my view is a red herring," says Ian Shepherdson of High Frequency Economics. Plus, Stephen Slifer and Ethan S. Harris at Lehman Brothers Inc. think the low 1% household saving rate, measured as a percentage of aftertax income, is not such a big issue, either: "We found that if realized capital gains are included, and the saving rate recalculated, it dipped from 10% in 1990 to 8% in 2000."

So far, the resilience of household spending has cushioned some of the blows from a sharp cutback in capital spending and the largest liquidation of inventories in the postwar period. But in the first half of 2002, an end to inventory liquidation will begin to shore up factory output. "I expect an inventory-led recovery, with the manufacturing sector moving up," says Robert Shrouds of DuPont. "The old economy, such as autos, will move up first, [followed by] a second leg up in the tech sector." Gains in capital spending will require profit margins to stabilize. "That's not happening yet," says Ian Morris at HSBC USA, "but slower wage growth, falling energy prices, and continuing productivity gains should all begin to help margins recover so that investment will grow reasonably stronger in the second half."

A full recovery in capital spending may not come until 2003. Business outlays for equipment and construction typically turn up after the economy does, as companies wait to see demand and profits improve before shelling out for new projects. The problem this time is that a slow recovery in demand will come on top of the past overinvestment. Equipment outlays, especially for high-tech gear, doubled from 1994 to 2000, four times the pace of overall output, and the level of new investment remains historically high relative to cash flow.

Nor will companies be able to look abroad for much new business (table). The global downturn will continue to hammer U.S. exports. The 12-nation euro zone is close to--or perhaps already in--a recession, and growth prospects there in 2002 will be limited by rising unemployment. Japan will remain a basket case, as policymakers quibble over how to deal with banks' nonperforming loans. The rest of Asia will not turn around until the U.S. and its tech industries do. The same is true of Mexico, while Brazil and Argentina have their own homegrown problems.

Despite the unusual nature of this recession and the added downdraft from September 11 and the war, the biggest plus going for the economy in 2002 is stimulative policy. "I cannot find any other recession in the last 50 years that has been met with as much countercyclical fire power as this one has," says Anthony Chan of Banc One Investment Advisors. Given that Fed rate cuts typically take 6-12 months to work through the economy, nearly half of the Fed's cuts have not yet been felt. Coming tax cuts and the boosts to government spending associated with the war and homeland security will also add to growth.

Almost all of the economists based their forecasts on the thesis that the U.S. will not be hit with any new terrorist attacks. A risky assumption, perhaps, but any assault may not affect the economy as sharply as the September 11 events did. As Diane C. Swonk of Bank One puts it, "the ability of those events to disrupt commerce...has been greatly diminished. We have already lost that side of our innocence and, as a result, can't lose it again." By James C. Cooper and Kathleen Madigan